Stressed Out: Office Depot Needs Merger With Staples, But Regulatory Obstacles Remain

 | Mar 22, 2016 | 12:56 PM EDT
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This article is part of a Real Money series on 20 companies investors should consider adding to their distressed watch list.

To hear J.P.Morgan analysts tell it, Office Depot (ODP) is in a fight for its life as it goes through the Federal Trade Commission antitrust investigation of its proposed merger with Staples (SPLS).

"While there is an upside on an approved deal, we don't see much outcome control for Office Depot if the deal is blocked," the firm said in a note earlier this month. "This is the management team's best exit in light of the company's sliding competition positioning."

On Monday, the first salvo in that existential battle was launched when lawyers for the two office supply outfits made their opening remarks to U.S. District Judge Emmet G. Sullivan. In the hearing, Sullivan will decide whether to issue a preliminary injunction blocking the deal ahead of a full trial that is scheduled to begin in May.

Staples and Office Depot have previously indicated that any injunction ahead of the May trial will scuttle their agreement.

And while Office Depot stands to make $250 million if the merger does not go through, thanks to a breakup agreement, analysts at J.P.Morgan see the secular headwinds of the retail sector as too much for Office Depot to overcome.

"We see lots of upside if the deal is approved, but long-term questions if it isn't," the recent note said. "As discussed in our merger math note, we believe there are significant synergies in a potential SPLS/ODP merger. However, secular and cyclical challenges remain a headwind and we believe that synergies are in the process of cresting."

Office Depot is a member of Real Money's Stressed Out index of 20 troubled companies that carry unsustainable debt loads and have a history of burning cash and resources in the absence of steady cash flow. 

The most glaring concern of the company's financial profile is the fact that it has more than doubled its debt over the past four years. The company went from having debt of about $659 million in 2012 to $1.58 billion in 2013. Its debt level has remained in that area ever since.

Despite the mounting debt, Office Depot has sufficient liquidity, between its $1.2 billion credit revolver and the $958 million in its cash reserves. But the merger is critical to help the company regain its competitive position.

The FTC is arguing that a tie-up of the two companies would be illegal: Combined, they sell nearly 80% of the pens, paper, file folders and other "consumable office supplies" to Fortune 100 companies.

FTC lawyer Tara Reinhart also argued that Growth Seeker holding Amazon's (AMZN) presence in the office supply space was not enough to keep the market for large corporate customers competitive.

Office Depot has already achieved $330 million in incremental synergies thanks to its store closings ahead of the merger. However, those synergies are estimated to peak at $750 million and have already begun slowing down.

The company's 2016 internal estimates of earnings before income tax stands at $500 million, up from $460 million last year; but J.P.Morgan pegs earnings at $444 million.

Office Depot CEO Roland Smith has previously stated that this litigation is hurting its operations. "Primarily due to the impact of store closures, continuous challenging market conditions, and an ongoing business disruption from the extended regulatory approval process related to the pending acquisition by Staples, the company expects this disruption to continue through at least the first half of 2016, while the company completes the ongoing litigation."

That disruption is about to be alleviated one way or another. If Judge Sullivan decides to issue an injunction, then the deal is effectively off and Office Depot is once again on its own. If Sullivan rules in favor of allowing the merger to proceed, Office Depot still faces the hurdle of the FTC hearing. Office Depot's stress levels wont be abating any time soon.

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